Stock Picking Basics





Kerry Back

Gordon Growth Model

Growing perpetuity

  • Cash flows \(C_1 = c\), \(C_2 = (1+g)c\), \(C_3 = (1+g)^2c\) and so on forever.
  • Discount rate \(r>g\)
  • PV is

\[ c\left[\frac{1}{1+r} + \frac{1+g}{(1+r)^2} + \frac{(1+g)^2}{(1+r)^3} + \cdots\right] = \frac{c}{r-g}\]

Gordon model

  • We want to value cash flows to shareholders
  • \(r=\) required return on equity
  • Payouts to shareholders = dividends + repurchases - net issues
  • Assume earnings, payouts, and book equity all grow at rate \(g<r\).
  • Define ROE to be earnings divided by lagged (beginning of year) equity.
  • Set \(k =\) payout ratio \(=\) payouts / earnings.

  • Equity grows by earnings minus payouts = \((1-k) \times\) earnings.
  • Earnings \(=\) ROE \(\times\) lagged equity.
  • \(g=\) % change in equity \(=\) growth in equity / lagged equity

\[=\frac{(1-k) \times \text{ROE} \times \text{lagged equity}}{\text{lagged equity}}\]

\[= (1-k) \times \text{ROE}\]

  • Value of stock is next year’s payout / \((r-g)\).
  • Next year’s payout is \(k\) \(\times\) next year’s earnings.
  • Next year’s earnings \(=\) ROE \(\times\) current book equity.
  • Price-to-book ratio \(=\) market value of stock / book value of equity

\[=\frac{k \times \text{ROE}}{r-(1-k)\times \text{ROE}}\]

Dupont Analysis

\[\text{ROE} = \frac{\text{Net Income}}{\text{Sales}} \times \frac{\text{Sales}}{\text{Lagged Assets}} \] \[\times \frac{\text{Lagged Assets}}{\text{Lagged Equity}}\]


\[= \text{Profit Margin} \times \text{Asset Turnover}\] \[ \times \text{Leverage}\]

Security Analysis

Sell side and buy side

  • Sell-side analysts work for brokerage firms and provide research to brokerage clients.
    • They are a cost center and research is provided free to generate business (= commissions or advising fees).
  • Buy-side analysts work for investment funds who use the research to pick stocks.

Technical versus fundamental

  • Fundamental analysts forecast important ratios and growth rates to produce earnings forecasts and price targets as in Gordon/Dupont.
  • Technical analysts use past prices to generate recommendations.
    • Example: support and resistance levels. Previous minimum (support) and maximum (resistance) stock prices are regarded as difficult to breach. But if breached, the trend is expected to continue.
    • Example: moving averages.

Quantitative Investing

  • Quantitative investing means using quantifiable signals to pick stocks and/or to time the market.
  • Signals can include the ratios and growth rates used in fundamental analysis and the signals used by technical analysts.
  • Signals can also include
    • satellite and drone image data,
    • sentiment analysis of social media, traditional media, and company announcements,

Efficient Markets Hypothesis